Definition
The term risky asset conversion ratio refers to a measure that assesses the proportion of assets that may be difficult to convert into cash. The risky asset conversion ratio is useful to lenders that want a more accurate assessment of a company's assets.
Calculation
Risky Asset Conversion Ratio = Risky Assets / Total Assets
Where:
Risky assets are those assets not readily converted into cash, less applicable depreciation or amortization. Examples of risky assets include intangible assets and equipment that has been customized by the company to accommodate their operating requirements or production processes.
Explanation
Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand the overall liquidity position of a company is by calculating their risky asset conversion ratio.
The risky asset conversion ratio provides the investor-analyst with information in terms of the ability of a company to liquidate certain assets. The value of these risky assets is then divided by the total assets of the company to determine the proportion of assets that might not be as valuable as shown on the company's balance sheet. The types of assets that fall into the "risky" category include intangible assets in addition to equipment and machinery that has been customized by the company and may be difficult to sell in the event of liquidation.
Example
The CFO of Company ABC would like to better understand the value of the company's assets since their revenue forecast indicates it may be a difficult fiscal year for the company. She asked her team to calculate the company's risky asset conversion ratio to determine the proportion of assets not easily converted into cash. Her team categorized the following assets as risky and indicated the value of these assets (net of depreciation or amortization): intangible assets ($3,500,000), customized plant equipment and machinery ($12,750,000). Company ABC's total assets were $125,000,000. The analysts reported the company's risky assets as:
= ($3,500,000 + $12,750,000) / $125,000,000 = $16,250,000 / $125,000,000, or 13%
Company ABC's CFO was relieved to find only 13% of the company's assets could not be readily converted into cash in the event of liquidation. This information will help the CFO negotiate with lenders if the company's revenue forecast is accurate and the company experiences a contraction in sales.
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